Interest Rates & Bond Valuation

Chapter 6 Bonds and Bond Valuation Term Structure of Interest Rates

CHARACTERISTICS OF ALL DEBT INSTRUMENTS

A. Pay Interest (coupons) and have a fixed maturity value ($1000 for corporate bonds). B. Indenture Agreement
1. Loan agreement between lender and borrower. 2. Appoints the trustee; a fiduciary responsible for guarding the lenders' interests. 3. Indenture agreement provides for legal remedies if terms & conditions of indenture are not met.

CHARACTERISTICS OF ALL DEBT INSTRUMENTS

C. Sources of risk
1. Default; probability of not getting all of the promised interest and principal. 2. Price; changes in prices as interest rates change over time. The longer the time to maturity, the greater the sensitivity. (See Fig 7-3) 3. Purchasing power; effects on inflation on buying power of coupon income. 4. Liquidity: inability to buy or sell at intrinsic value due to inactive market or small float.

TYPES OF BONDS
A. Mortgage bonds: bonds secured by real property B. Equipment trust certificates: bonds secured by equipment (rolling stock) C. Debentures: unsecured bonds (no collateral). D. Revenue bonds: interest paid only if a specified level of earnings is achieved

TYPES OF BONDS
E. Convertible bonds: bonds that may be converted into the firm's common stock F. Variable interest rate bonds: coupons that change with changes in interest rates G. Zero coupon bonds (also called pure discount bonds): dont pay coupons. H. Callable Bonds: can be called prior to stated maturity (early redemption).

BOND VALUES AND BOND YIELDS

A. Bond valuation model;
1.
2.

VB = Coupon * PVIFA + Face Value * PVIF

The value of a bond (VB) is a combination of a present value of an annuity (PV of coupons to be received) and PV of face value of the bond. VB is also the PV of all expected cash flows

CFn VB n n 1 (1 k b )

for n 1, 2, 3, ..., N

BOND VALUES AND BOND YIELDS

B. Current yield = coupon divided by the [current] price (PV) C. Yield to maturity (YTM) = rate earned if held to maturity D. Interest rates and bond values
1. YTM go up --- bond prices go down [and viceversa] 2. If company gets riskier, then YTM goes up and prices down [and vice-versa].

USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES

A bond pays a coupon of $120 per year, paid semiannually. The bond matures in 20 years and has a face value of $1,000. If the current YTM rates are 9 percent, how much should this bond sell for? 1. ENTER 20 [2nd] [N], [N]: Display: N = 40.00 2. ENTER 9 [I/Y]: Display: I/Y = 9.00 3. ENTER 60 [PMT]: Display: PMT = 60.00 4. ENTER 1000 [FV]: Display: FV = 1,000.00 5. PRESS [CPT] [PV]: Display: PV = -1,276.02

USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES

A. What If Examples
1. Suppose the YTM is 11 percent; "I/Y" = 11. Enter 11, press [I/Y], then [CPT] , then [PV]; -1,080.23. 2. If the YTM is 12%; enter 12, press [I/Y], then [CPT], [PV]; PV = 1,000.00 or $1,000.00. 3. If the YTM is 15%, the price [PV] is $811.08. Note as YTM increases, VB decreases

TERM STRUCTURE OF INTEREST RATES

A. Factors Influencing Interest rates. 1. Federal Reserve Monetary Policy. 2. Investor expectations about economy. 3. Inflation expectations. 4. Business Decisions.

TERM STRUCTURE OF INTEREST RATES

B. Composition of Nominal Interest Rates. 1. Real rate of return. 2. Inflation premium. 3. Default premium. 4. Liquidity premium. 5. Maturity Risk premium

TERM STRUCTURE OF INTEREST RATES

C. r = r* + IP + DRP + LP + MRP
r

= r* = IP = DRP = LP = MRP =

required return on a debt security real risk-free rate of interest inflation premium default risk premium liquidity premium maturity risk premium

TERM STRUCTURE OF INTEREST RATES

Interest Rate (%) 15

Maturity risk premium

10

Inflation premium

5
Real risk-free rate

0 1 10 20

Years to Maturity

HOMEWORK ASSIGNMENT
A. Critical Thinking & Concepts: 6.1, 6.2, 6.5, 6.9, 6.15 (part c) B. Questions and Problems: 3, 4, 5, 22, 23 (parts a, b)